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Flagstone Weekly Update 05 December 2017

5th December 2017

UK Economic Headlines

OECD cautions the Bank of England against further rate risesAnalysts at the Organisation for European Co-operation and Development (OECD) believe that the Bank of England (BoE) should be wary about raising UK interest rates further next year. The international body warned that the current 3.0% UK inflation rate is likely to lead to lower consumer spending that will weaken economic growth while it is likely that UK unemployment will rise from its current level of 4.3%. Both the BoE and the Office for Budget Responsibility (OBR) believe that the inflation rate will peak at around the current 3.0% level this year and then drop back towards the official target rate of 2.0% in 2018. When the BoE raised interest rates at the beginning of November, it stated that its role is to find a balance between controlling inflation and ensuring that there is sufficient stimulus in the economy to aid economic growth. However the OECD report suggests that in the absence of wage pressures the central bank should look through the temporary inflationary impact of currency depreciation. The organisation cautions that, such is the capacity for Brexit to cause further shocks to the economy, the government should stand ready to alter this course of action and add stimulus to the economy via increased spending, if necessary back in 2018.

UK banks pass Bank of England stress tests but Brexit concerns still lingerAll seven major UK banks have passed the latest stress tests set by the Bank of England (BoE) for the first time, even in the event of there being no Brexit deal with the European Union (EU). The results mean that UK banks would be able to continue lending even if the UK were to suddenly leave the EU in 2019. The test was first introduced in 2014 and is designed to ensure that the banks have sufficient liquidity and relatively strong capital positions to weather an economic storm. The latest results show that all of the major UK banks are now in a position to withstand a hard Brexit and still keep lending. However, Barclays Group (Barclays) and the Royal Bank of Scotland Group (RBS) only passed the hurdle rate set by the BoE because the regulator took account of efforts they had already made to increase their financial strength since the end of last year (i.e. the date that the tests were intended to be applied). If the end-2016 CET1 ratios had applied, then both banking groups would have been slightly below their “Hurdle Rates”. However both banking groups did fall below their respective G-SIB systemic reference points which will require to be met by 2019. Meanwhile Brexit stress still lingers as the BoE has instructed lenders to add an extra £6.0bn to their capital buffers. The BoE has also signalled that it may increase the requirements again in 2018 over fears that the potential combination of a no-deal Brexit without a transition period and a global recession could strangle the flow of credit to the economy. The published positions by the BoE are as follows:

* Global systemically important banks (G-SIB’s) are held to a higher standard in the stress test than their Hurdle Rate and require to have a larger overall capital buffer.

* Global systemically important banks (G-SIB’s) are held to a higher standard in the stress test than their Hurdle Rate and require to have a larger leverage buffer.

UK export sales higher despite increased cost of raw materialsThe British Chambers of Commerce (BCC) reports that UK exporters have grown overseas sales in Q3-2017 despite rising prices of raw materials and uncertainty around future trading regulations. The business lobby group’s trade confidence index now stands at its third highest level since 2004. The report, based on a survey of 3,300 exporters, found that 44% of exporting manufacturers and 30% of exporting services companies had reported increased sales overseas in the third quarter. However the issue of rising prices for raw materials remains a big concern. 68% of exporting manufacturers cited exchange rates as a worry to their business alongside 49% in the services sector.

Highest UK manufacturing activity growth in four yearsThe latest IHS/Markit Purchasing Managers' Index (PMI) survey for UK manufacturing indicates that activity in the sector grew at its fastest pace in more than four years. The Index rose to 58.2 in November which is the best level in 51 months with exports playing a major role in the expansion. An IHS/Markit spokesperson said the results indicates that the domestic market had remained strong during the month and that new export orders primarily from the US and Europe played a significant part in the strong figures. But some economists question whether UK factories can maintain their current pace. The influential EY Item Club cautions that the outlook for manufacturing appears mixed with domestic conditions still looking challenging despite November's healthy orders.

Financial crisis loans’ auction underwayUK Asset Resolution, the state-backed body that manages the assets of the collapsed Bradford & Bingley and Northern Rock banks, has announced the formal launch of a £5.5 billion auction of home loans. The proceeds will go towards recouping more of the UK taxpayers’ money that was injected into the banking system during the 2008 financial crisis. UK Asset Resolution was established in October 2010 to manage the closed mortgage books of both Bradford & Bingley and Northern Rock which were nationalised in 2008 at the height of the credit crunch. The company looks after the Treasury’s 100% stake in the closed mortgage books and is responsible for about 148,000 customers holding £19.5 billion of mortgages and loans. The proceeds from the sale are expected to be used to repay the outstanding £4.7 billion Treasury loan to the Financial Services Compensation Scheme.

The Royal Bank of Scotland closes “bad bank”The Royal Bank of Scotland (RBS) has closed its “bad bank” (called Capital Resolution) which was set up to handle toxic loans after the financial crisis. It marks another milestone for RBS which has generated profits in the past three quarters and is gearing up for the UK Government to sell more of its shares. RBS, which remains 71% taxpayer-owned, set up Capital Resolution nine years ago during the financial crisis as it struggled with a large amount of toxic loans. This allowed RBS to separate its bad loans and other businesses no longer wanted from its good loans and business areas that management wanted to grow. The aim was to give investors more clarity and to help management to focus on growth areas. The non-core division made up nearly 40% of RBS’s risk weighed assets (RWA’s) in 2009 and which has now come down to 11% due to disposals that resulted in accumulated losses of circa £50.0 billion. RBS has folded the remaining £23.0 billion of unwanted assets back into the bank ahead of being sold. RBS is expected to report a further loss for the full year if it settles by the 31st December its dispute with the US Department of Justice over the sale of subprime mortgage bonds before the crisis.

Other Headlines

Economic sentiment brightens in eurozoneThe November European Commission’s economic sentiment indicator (ESI) for Europe shows that economic sentiment is gaining pace. However with inflation expectations on the continent rising slowly, it indicates that interest rates could remain low for some time yet. The ESI climbed to 114.6 from 114.1 which was in line with the economist consensus forecast and would be consistent with the bloc's annual gross domestic product (GDP) growth accelerating possibly to 4.0% in the final quarter of the year, up from 2.5% in the third quarter. Sentiment improved in most areas with the industrial index hitting its highest ever level to indicate industrial production growth of about 5.0%. Services sentiment suggested growth in the sector will pick up as well but retail confidence edged lower. Inflation expectations in the eurozone remained subdued with consumers’ inflation expectations for the coming 12 months picking up to 16.0 from 14.7 in October. Economists believe that the survey suggests the eurozone recovery might have picked up pace at the start of the fourth quarter. The slow rise in inflation expectations would appear to support the cautious approach of the European Central Bank (ECB) to normalising monetary policy with some economists predicting that the ECB will end its asset purchases in December 2018 and then wait until September 2019 before raising interest rates.

FTSE European 350 Bank Index rose slightly by +0.7% over the weekThe FTSE European 350 Bank Index has again risen slightly by +0.7% over the week to 4,429 as markets continue to “tread water” ahead of the Spanish regional election in Catalonia this month as well as waiting to see whether sufficient progress has been made in the Brexit discussions to satisfy the European Union so that a decision can be taken at the December summit of European leaders on the 15th December to move on to trade negotiations or whether the Irish border issue will prevent this happening.

ITRAXX Europe Senior Financials 5-year CDS Index improves by -2.1% over the weekThe ITRAXX Europe Senior Financials 5-year CDS Index* improved by -2.1% over the week, reducing to 47bps from 48bps, as financial markets welcome the news that the UK is believed to have substantially increased its exit payment offer which has potentially paved the way for a positive decision by European leaders on the 15th December to start free trade agreement negotiations (including a transition period) with the UK - albeit the Irish border issue may still prove an obstacle that could delay a decision until March 2018. (* We are now using Series 28 as the reference index which includes the restructuring of Banco Novo.)

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